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Patni Computers: It's four-in-one! - Views on News from Equitymaster

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Patni Computers: It's four-in-one!

Sep 6, 2006

Introduction to results
Patni Computer Systems (PCS) recently announced its results for 2QCY06 (the company's financial year ends in December). During the quarter, the company saw an impressive growth in its topline, driven by a combination of higher volumes, higher billing rates and favourable exchange rate movements. Margins saw an impressive expansion despite the salary revisions carried out, due in part to the favourable exchange rate movements, higher utilisation rates as well as a one-off item of reversal of payroll taxes for earlier years. Driven by the higher margins and considerably higher other income, the bottomline, adjusted for the additional provisioning due to re-assessed corporate taxes for earlier years, grew at an impressive sequential pace. For the half-year, the performance at the topline level has been good, but the bottomline has witnessed muted growth of 8.0% YoY (adjusted for one-off items).

Consolidated Financial Performance (US GAAP): A snapshot
(Rs m) 1QCY06 2QCY06 Change 1HCY05 1HCY06 Change
Sales 5,776 6,561 13.6% 9,068 12,336 36.0%
Expenditure 4,753 5,249 10.4% 7,262 10,002 37.7%
Operating profit (EBDITA) 1,022 1,311 28.3% 1,806 2,334 29.2%
Operating profit margin (%) 17.7% 20.0% 19.9% 18.9%
Other income 11 191 1696.9% 94 202 114.1%
Depreciation 193 205 6.3% 305 398 30.6%
Profit before tax 840 1,298 54.5% 1,595 2,137 34.0%
Tax 197 1,445 632.0% 292 1,642 463.1%
Profit after tax/(loss) 642 (147) 1,304 496 -62.0%
Net profit margin (%) 11.1% -2.2% 14.4% 4.0%
No. of shares (m) 139.4 137.4 125.0 137.4
Diluted earnings per share (Rs)* 13.6
P/E ratio (x)* 28.1
* On a trailing 12-month basis

What is the company's business?
PCS is India's sixth-largest software services exporter, engaged in providing software solutions and services, domestically and internationally. The company's sphere of offerings includes application development and integration, application maintenance, enterprise application systems, R&D services and business process outsourcing services. PCS has the GE Group as its largest client, with a revenue contribution of 14.5% to consolidated revenues in 2QCY06. Among verticals, PCS has a substantial presence in the financial services, insurance, telecom and manufacturing verticals. The share of revenues from these verticals in 2QCY06 was over 80%.

What has driven performance in 2QCY06?
It all comes together for the topline: During the quarter, PCS recorded an impressive 13.6% QoQ growth in its topline. This was driven by good volume growth, aided by higher billing rates as well as favourable exchange rate movements. Volumes grew sequentially by 7.2%, while pricing saw an up-tick of about 2.5% QoQ. This apart, the company's realised rupee rate based on the convenience translation method* was also higher, at Rs 45.87 to the dollar (Rs 44.48 in 1QCY06). Revenues in dollar terms, on the other hand, grew at 10.2% QoQ, thus signifying that the beneficial impact of the rupee movement was 3.4%.

Client metrics continued to improve in 2QCY06 as compared to 1QCY06. The company added a net of 14 clients during the quarter, and the active client base now stands at 220. The total number of US$ 1 m clients increased to 64 (61 at the end of 1QCY06). As regards GE, its largest customer, revenues constituted 14.5% of the total in 2QCY06 as compared to 16.5% in 1QCY06 and 23.0% in 2CY05. In absolute terms, GE revenues marginally fell on a sequential basis by 0.1%. Non-GE clients, on the other hand, grew at a sequential rate of over 16%.

As regards the industry-wise performance of the company, PCS saw strong traction in its major verticals such as manufacturing (grew at nearly 20% QoQ), financial services (11.4% QoQ), telecom (20% QoQ), the ISV practice (16% QoQ) and product engineering (10% QoQ). Thus, the overarching feature of this quarter's performance has been everything coming together at one time – volume growth, billing rate increases, favourable exchange rate movements and strong traction in key verticals, which was also the case for Infosys.

Margins power ahead despite salary revisions: During the quarter, PCS saw an impressive 229 basis points expansion in its operating margins. This was mainly driven by the favourable exchange rate movements of the rupee, as well as higher utilisation rates and lower SG&A expenses. PCS gave a 17% hike in its offshore salaries, while for its onsite staff, the hike was to the tune of 8%. However, it should be noted that there was a one-off item of reversal of payroll taxes for earlier years to the tune of US$ 7 m (Rs 321.1 m). Adjusted for this, sequential operating margins saw a 260 basis points fall, and in absolute terms, were lower by 3.1% QoQ.

Over a longer-term time frame, we expect margins to trend downwards across-the-board for software companies, given the various demand and supply-side issues impacting wage inflation, the major cost head, such as increasing competition for talent, a general shortage of talent at the mid-management levels and the imperatives to retain key employees, requiring higher raises each year. PCS' attrition rate (annualised) stood at as much as 21% this quarter, excluding BPO, and this is a clear sign of the pressure that these companies are facing in order to retain crucial talent.

Higher margins, other income power the bottomline: It should be noted that the major reason for the company having reported a net loss this quarter has been re-assessed corporate taxes pertaining to earlier years. These stood at US$ 27.1 m (approx. Rs 1,243 m). Thus, this is largely in the nature of a one-time item, and adjusted for this, the company's performance at the net profit level has been strong, at 19.2% QoQ. This was driven by higher margins, as well as considerably higher other income (up by as much as 1,696.9% QoQ).

Performance in the recent past…
3QCY05 4QCY05 1QCY06 2QCY06
Sales growth (%, QoQ) 9.9 7.2 3.7 13.6
EBIDTA margins (%)* 18.0 19.9 17.7 15.1
Profits growth (%, QoQ)* 14.8 (7.4) (2.8) 19.2
* Excluding one-off items.

What to expect?
At the current market price of Rs 382, the stock is trading at a price to earnings multiple of 28.0 times its trailing 12-month earnings. The company comfortably out-performed its guidance for the quarter (13.6% QoQ revenue growth against the projected guidance of 6% QoQ, and 19.2% QoQ growth in net profits against a 24% QoQ fall projected). During the quarter, PCS acquired ZAiQ Technologies, a US-based design and verification company, which is expected to strengthen its existing verification and validation practice.

For 3QCY06, the management has guided for a 4.5% to 5% QoQ growth in revenues, and for net income to be in the range of US$ 18 m to US$ 18.2 m, a QoQ growth of 8.1%, at an exchange rate of Rs 45.48 to a dollar. This is a welcome change from the past, where PCS has consistently under-performed its larger tier-I peers, particularly on the bottomline front. Undoubtedly, the rupee movement has helped PCS' cause to a great extent. Going forward, the consistency of this performance will need to be watched if the stock is to be warranted as an investment vis-à-vis larger peers like Infosys and TCS, which have maintained more consistent financial performances, have greater scalability and lower attrition rates.

* The convenience translation method implies translating the financial data prepared in accordance with US GAAP at the noon buying rate in the City of New York on the last business day of such period for cable transfers in Rupees as certified for customs purposes by the Federal Reserve Bank of New York.

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